Aflac Incorporated (AFL) Earnings Call Transcript & Summary

Good afternoon, everyone. I'm Ryan Krueger from KBW. Really pleased to have Aflac with us this year. And representing the company is Max Brodén, who is their Chief Financial Officer. [Operator Instructions]

So take -- to start off, Max, I was hoping you could discuss the U.S. claims, impact that you saw in the second quarter, both from COVID as well as social distancing impacts. And then how you're thinking about those 2 opposing forces as we head into the second half of the year?

Yes. So thank you, Ryan. So if we start with the COVID impact on the U.S., we had about 5,000 claims so far in the second quarter, and we have recorded about $31 million of claims so far. And about 70% of that is IBNR that we put up. So it's a fairly low number in totality so far. It is interesting to note as well that about 80% of the claimants that we've seen have been short-term disability. And a fairly low claim count coming through our hospital indemnity products. At the same time, the other factor, obviously, as we mentioned, has been our, let's call it, normal claims or non-COVID claims. So with social distancing taking effect in the second quarter, obviously, a lot of people are not going for physicals, they're not going for dental cleanings and there's a postponement of electric surgeries, et cetera. So we obviously have seen claims activity decline. And that manifested itself in a lower benefit ratio overall in the U.S. in the second quarter where our benefit ratio dropped year-over-year by a little bit more than 500 basis points. So you've seen so far that the social distancing impact on non-COVID claims have far outweighed the impact from COVID claims. At the same time, we think -- as we then look into the second half, we would expect a continuation, obviously, of the COVID claims to come through. At the same time, as the economy is open and you have less of a social distancing impact, you should see a normalization in the normal claims on accident products, on hospital products, et cetera. And you could even see a potential pent-up demand, so to speak, in terms of dental cleanings being postponed, and that being surgeries that have been postponed as well. So we don't necessarily, obviously, view the benefit ratio in the second quarter as something that we would expect to be that far from our run rate, obviously. And we would even expect that we, in the near term, could see a normalization in the benefit ratio. And temporarily, it could go up on some lines of business because of a pent-up demand in terms of -- if you think about people going for physicals, cleanings, et cetera.

And then in Japan, your COVID claims were extremely modest in the second quarter. But I know it didn't seem like social distancing really had much of an impact on medical claims there either. So can you touch on why that was?

So in Japan, I think that the difference has been a little bit how the hospitals have actually operated. So in Japan, we've seen that hospitals operated almost normal. And I think part of the reason why that's been the case is because of the lower spread of the virus. So we have had fewer patients coming into the hospitals with COVID-19. Therefore, they didn't have to shut down as much of their normal operations. So you have not seen, to the same extent, the postponement of physical selective surgeries, et cetera. So that is really, to some extent, one of the drivers why Japan saw a more normal claims environment. The other thing I mentioned as well is -- you asked correctly the question specifically on medical in Japan. But I do want to mention that, obviously, our large block of policies in Japan is cancer and cancer is not taking a break from COVID. So we see more normal claims activity when it comes to cancer.

And then, I guess moving beyond COVID claims and just thinking about the Japan benefit ratio. Overall, I guess, over the intermediate term, can you talk about some of the key trends that are affecting the Japan benefit ratio? I'm thinking about certain things like hospital stays, mix shift in new business, those types of impacts?

Yes. So obviously, in Japan, a long-term driver that we have seen has been in the shorter hospital space. And I'm sorry, I need to open a door for my dog. This is what happens when you work from home.

No worries at all. I've been there many times.

So we've seen shorter hospital space for patients whenever they've been admitted to a hospital. And this has been a long-term trend. Not only is that something that obviously is driven by better medical technology, it's obviously good for patients. And because we -- part of our -- the benefits that we pay is per day admitted into the hospital. So that lowers the total claims that we pay on a medical policy even at cancer policy. You've also seen, obviously, a push towards more outpatient services. That is also a trend that is beneficial to us. And overall, you've seen -- and this driver, the underlying driver for all of this, obviously, is the greater need for hospital services and hospital beds, et cetera, because of the aging population in Japan. And at the same time -- so you've seen an increase in demand for hospital beds, but actually the supply of hospital beds has actually declined because you continue to have an even greater demand for nursing care homes in Japan. And what the Japan government has done is to actually convert some hospitals into nursing care homes. So there are strong underlying drivers for this. So when we drill down and we look at what are the core underlying drivers of the improvement in the benefit ratio, this is probably the strongest driver. And we talked about this for many, many years, and it continues to be a very strong driver in terms of the actual-to-expected experience for us. When we look forward, we do not assume in our pricing that this will continue, but we obviously take recent trend into consideration for pricing of new products and new business.

Got it. So I guess is it -- given that, is it reasonable to expect, over time, continued downward benefit to the benefit ratio in Japan?

If you have a continued shortening of the hospital -- days in hospital per se, then you should have a continued improved actual to expected. If that were to flatten out, then you will obviously not see that improvement anymore.

Got it. I want to shift to the digital investments that you've been making in both Japan and in the U.S. Can you discuss those in more detail as well as talk about to what extent that you're accelerating those investments in this type of environment?

Yes. This is something that we obviously have been working on for quite some time. But what COVID has done and what the whole work-from-home environment has done is that it basically has accelerated the need to go digital. And we, as a company and we as an industry, are very paper heavy. And if I start with Japan, Japan, in particular, is very paper heavy. So we have accelerated an initiative to have Aflac Japan go paperless. And this is a very, very important initiative, and it's a pretty significant and big initiative as well. We would estimate that the accelerated expense for this is about JPY 10 billion. But that should yield about a JPY 3 billion benefit per year in run rate reduced expenses going forward. So this is important in terms of the full operational and customer experience, the way we can build and sell products in the future then obviously, it reduces risk as well for us. It's obviously -- they're in the -- in an area with a lot of earthquakes. And obviously, if you have paper and you shake the building around, that's not necessarily a good thing. So there are many reasons why it actually makes sense for us to accelerate this. In the U.S., it has been more around the sales experience. So we have accelerated spend on our enrollment, digital enrollment capability. We have accelerated spend on our digital onboarding in our group ecosystem. We have accelerated spend also on the self-service portal. So within the My Aflac app, we have added capabilities there to make it easier and also expanded what you can do in terms of self-service. And we also expanded and accelerated some spend on automating claims as well. And all that -- you take all of this together, in the U.S., we're talking about an accelerated spend to the magnitude of about $25 million.

Got it. When you put these things together with the other impacts in the business, can you talk about how you see expense ratios in both Japan and the U.S. trending over the next few years?

Yes. So first of all, I do want to mention that our expense ratios have been increasing the last couple of years. And it is partly because of the underlying business mix shift in our in-force that have pushed up the expense ratio. In Japan, it's because of a greater contribution into our in-force from third sector and that's from first sector business. And in the U.S., it's from more improved products being sold that carry a higher expense ratio and a lower benefit ratio. So there's some underlying elements that have pushed up our expense ratio. But obviously, the main driver has been increased investment spend. We should continue to see that going into 2021. After that, I would expect us to have some leveling of our expense ratio. But I do want to highlight as well that what is important here, this is -- I do like to talk about it in terms of expense ratio and not just hard expenses, because it's very much a factor of what we're doing on the revenue side. So for us, it becomes important to drive both revenues and to manage expenses in order to get the expense ratio down. So it will be a combination of both where expenses needs to come down. And then also that we need to generate greater revenue growth in order to get the ratio down over time.

Got it. I'm going to shift to premium persistency in the U.S. in particular. Can you discuss how the economic weakness we're currently experiencing is causing any changes to persistency in the U.S., it -- so far and as you look forward over the next few quarters?

So our persistency so far by the -- at the end of the second quarter has not moved very much at all. So we reported 78.3% persistency rate for the second quarter. And that needs to be put in context of, we had many states with grace periods in place, which means that we did not lapse policies even if we didn't necessarily receive premiums on time the same way we would normally do. So that means that, that persistency rate at the end of the second quarter becomes somewhat inflated because of these state orders that we were not allowed to lapse the policies. And this varies by state, but most states, a very significant portion, those grace periods ended on June 1. Now don't confuse grace periods with the -- all of a sudden, we're giving away free coverage. That's not what it's about. It's simply about we're not canceling the policy at that point in time. So it's really the only number that, to some extent, gets inflated here is the persistency rate. Now going forward, we would expect some high relapses to come through. And it's obviously -- the cost of grace periods expiring and also the payment protection act, that's going to lapse as well. So you have less support going to small businesses. We are obviously a company that very much cater to the small business segment. So we are somewhat economic sensitive from that. So if you put all of this together, we would expect some weakness in terms of lapses to come through and that should hit our persistency here in the second half. If you go back in history and you look at all the businesses, [ we have seen ] increases in unemployment in the past. You can go back to the sort of last economic downturn that we had in '08, '09. And we did see that our persistency did weaken in the range of 200 to 400 basis points, just to give you a sense for how our business has reacted in the past.

Is the primary reason for the reduction in persistency due to economic weakness? Or is there also some influence from the owners of these policies not having the opportunity to interact with the salesperson to influence the renewal within the workplace as well?

Yes. The interaction with the salesperson is a fairly important one. And so very often, you have reminders in relationships that go out between the agents and the small businesses. For example, very often, the agent helps and supports in terms of even filing claims. So there's a fairly strong relationship there. So there is a correlation between if you have an agency count go down, the count that an agent may have covered in the past, if that agent is no longer with the company and they're no longer servicing that company. And that's now a so-called dormant account. And the probability for lapse, obviously is higher under that circumstance as well.

In Japan has there ever been much of a correlation between persistency and economic conditions?

So we've seen very little impact from economic conditions to the persistency rate. And there are several factors for that. So the first one, obviously, being that unemployment does not tend to move a lot in Japan the same way it does in the United States. So that factor leads to better persistency. The other factor I would say is also that individuals are less economically sensitive from the standpoint of they generally have greater savings. So there's not a need to the same extent to lapse the policy for economic reasons. And the Japanese policyholder base, arguably, have a very good understanding for what the products do and the need for them, especially when it comes to cancer. So there's a great reluctance to give up coverage. And I'll say -- and the last piece has to do with the pricing of the products because we price by age in Japan, and that means that if you lapse the policy and ever want to buy coverage again, then you're going to come in at a higher age category in terms of pricing. So it's going to be a lot more expensive for you. And that's generally fairly well understood in Japan, and that obviously drives behavior and leads to better persistency.

On the sales side, on the second quarter call, you had guided to modest improvements in Japan and U.S. sales in the second half of the year relative to the first half. As the economy continues to gradually reopen, can you talk about why you don't expect more of a, I guess, more significant near-term recovery in the back half of the year?